In brief

• A moderation in the upcoming April CPI print should take the edge off recent market volatility as the sell-off was largely driven by concerns over over-tightening by the Fed and recession risks
• Recent de-rating of equity multiples and widening credit spreads offer investors opportunities in both equities and fixed income
• Staying diversified: Quality stocks with resilient earnings growth and ample pricing power should offset slowing growth momentum and inflation. Investment-grade bonds will provide a steady income in a tepid growth environment and bring down overall portfolio volatility. 
  

Global equity markets have been marred by volatility over the past month, due to growing concerns about Federal Reserve (Fed) policy error and a potential recession. Stocks have sold off as a result, with MSCI AC World Index declining more than 16.6% year-to-date (YTD) and the S&P500 falling more than 15.7% YTD.

Upcoming April Consumer Price Index (CPI) print could prove pivotal

Much of the downward pressure on equities has stemmed from stickier than expected inflation, leading to concerns about the Fed overtightening as it attempts to move back in line with the curve. As such, the path of the market and risk sentiment going forward hinges on the Fed’s battle against inflation, starting with April’s CPI print.

For April’s CPI, we expect inflation to showcase some signs of moderation, particularly as the price of transitory components such as used cars, gasoline prices and commodity prices begins to wind down. Shelter inflation could also slow down, as 30-year mortgage rates moving past 5% will likely soften demand within the housing market. We expect modest sequential gains of 0.2% overall, 0.3% excluding food and energy, cutting year-over-year headline inflation from 8.5% to 8.1% and core inflation from 6.4% to 5.8%. A moderation in inflation should help boost risk sentiment as it would provide a reason for the Fed to tone down its hawkish stance and ease concerns about the Fed being behind the curve. On the other hand, a continuation of March’s record CPI number may induce further selling pressure.

There are already some suggestions that central bank hawkishness is abating. After the highly anticipated 50 basis points (bps) hike during the May Federal Open Market Committee meeting, market expectations have now moved meaningfully away from a 75bps hike scenario, with Fed Fund Futures currently pricing in 50bps hikes in both the June and July meetings at 88% probability. Reading the tea leaves of recent Fed comments, the Fed will likely do its utmost to engineer a soft landing for the U.S. economy. Bullard and Waller both argued against the notion that the Fed was behind the curve, while Bostic deemed a 50bps hike as “rather aggressive”. Overnight index swap forward rates are now expecting Fed Fund Rates to reach 2.7% – 2.9% at the end of 2022, indicating three additional 50bps and two additional 25bps hike between now and the end of the year. 

Slowing global growth has dampened investor sentiment

From a growth perspective, the narrative is arguably less rosy. COVID-19 in China and geopolitics in Europe continue to be a near-term overhang on global growth. In China, the resurgence of COVID-19 and the central government’s adherence to its zero-COVID policy has tightened supply chain bottlenecks and weighed on domestic economic activity. China’s April Purchasing Managers’ Index showcased a slowdown in both manufacturing and services industries due to lockdown measures, resulting in Chinese export growth falling to its lowest level in two years. In Europe, the war in Ukraine continues to push up input costs, with surging prices dampening consumer sentiment and slowing the region’s growth.

Having said that, we think downside risks to growth in China and the U.S. are less alarming. In China, an inevitable easing in the number of COVID-19 infections, as showcased by declining cases in Shanghai over the past few days, will give the economy a much-needed re-opening boost. Secondly, further policy easing will likely provide some relief to the Chinese economy in the meantime. Concerns over growth in the U.S. is also relatively premature given the continued strength of corporate balance sheets and domestic consumers.

Investment implications

In the near term, we keep a close eye on the trajectory of inflation which should determine much of the Fed’s actions over the next few months. We think a moderation in April CPI will be a tailwind for risk assets while any upside surprise could drive further market volatility. Growth concerns are more pronounced in Europe compared to the U.S. and Asia.

To hedge against inflation and growth risks, investors should consider quality companies offering historically more stable earnings growth, and ample pricing power to protect against the impact of inflation on profit margins. Exposure to energy, industrials, and materials stocks also makes sense given the support for commodity prices due to the continued short fall of supply relative to demand.

The recent de-rating of equity multiples due to higher real rates (contributing most significantly to the negative YTD returns, see Exhibit 1) may also provide investors a reasonable entry point given how stretched equity valuations have been over the past two years. In particular, long-term investors may want to add info tech exposure, as valuations in the sector have moderated from 29x 12 months forward price to earnings (12M Forward P/E) at the start of the year to 22x 12M Forward P/E. The info tech sector should see strong earnings growth given secular demand  for software products and services and continued demand for hardware.

Exhibit 1: Negative year-to-date returns have largely been driven by multiple contraction
Year-to-date total return USD

Source: FactSet, MSCI, Standard & Poor’s, J.P. Morgan Asset Management. *All return values are MSCI Gross Index (official) data, except the U.S., which is the S&P 500. **Multiple expansion is based on the forward price-to-earnings ratio. ***Earnings per share (EPS) growth outlook is based on next 12-month aggregate (NTMA) earnings estimates. Diversification does not guarantee positive returns or eliminate risk of loss. Past performance is not a reliable indicator of current and future results.
Guide to the Markets –Asia. Data reflect most recently available as of 11/05/22.

For income seeking investors, the current environment also warrants a re-visit into the fixed income space. From a valuation perspective, the recent widening of corporate credit spread has brought fixed income into attractive territory. In addition, corporate fundamentals remain healthy and corporate default rates are expected to remain low throughout this year. Investment grade bonds provide much coveted downside protection to slowing growth momentum while offering investors a steady income stream. High yields may also offer exposure to market risk-on sentiment while downplaying overall portfolio volatility.

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